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Thursday, July 13, 2017

The Dark Side of Globalization: An Update on Country Risk!

The inexorable push towards globalization has stalled in the last few years, but the change it has created is irreversible. The largest companies in the world are multinationals, deriving large portions of their revenues from outside domestic markets, and even the most inward looking investors are dependent upon global economies for their returns. As a consequence, measuring and incorporating country risk into decision making is a requirement in both corporate finance and valuation. It is in pursuit of that objective that I revisit the country risk issue twice every year, once at the start of the year and once mid-year, at which time I also update a paper that I have on the topic, that you are welcome to read or browse or ignore.

The Globalization of Companies

There are some investors, especially in the United States, who feel that they can avoid dealing with risk in other countries, by investing in just US stocks. That is a delusion, though, because a company that is incorporated and traded in the United States can derive a significant portion of its revenues and earnings from outside the country. In 2015, the companies in the S&P 500, the largest market cap stocks in the US, derived approximately 44% of its revenues from foreign markets, down from 48% in the prior year.

Source: S&P

The composition of foreign sales is also changing, though gradually, over time, shifting away from the UK and Europe to emerging markets, as evidenced in the graph below:

Source: S&P

Lest you feel that this graph is skewed by the biggest companies in the index, 239 of the 500 companies in the index reported that foreign sales represented between 15% and 85% of their total sales and 13 companies reported that more than 85% of their sales came from outside the US. In 2014, two companies, Accenture and Seagate Technology, reported that all their sales were foreign, making them US companies only in name. (Many of you have pointed out that Accenture has significant US sales and that is true. I am just excerpting from the S&P report, which should lead you to question how S&P classifies foreign sales.) This phenomenon is not restricted to US companies, as the largest companies in most markets exhibit similar characteristics. While we can debate whether these trend lines are good or bad for consumers and investors, the consequences are real:

Fraying link to domestic economies: For decades, the conventional wisdom has been that the stock market in a country is closely tied to how well the economy of that country is doing. That relationship has been weakened by globalization and equity market performance around the world is disconnecting from domestic economic growth. Taking the US as an example, consider that equity markets in the US have been on a bull run, with indices up 170% to 200%, cumulatively since 2009, even as the US economy has been posting anemic growth.

Central Banking power is diluted: In the decades since the great depression, we have to come to accept that central banks can use the policy levers that they have at their disposal to move long term interest rates and to strongly influence overall economic growth, but that power too has been reduced by globalization and its unpredictable flows. It should come as no surprise then that the frantic efforts of central banks\ in the US, Europe and Japan, in the last decade, to use the interest rate lever to pump up economic growth or to alter the trajectory of long term interest rates have failed.

Taxing questions: When writing tax code, governments have generally assumed that companies incorporated in their domiciles have little choice but to accede to tax laws eventually and pay their share of taxes. While companies have historically played the tax game by delaying and deferring taxes due, their global reach now seems to have shifted the balance of power in their direction. In the United States, in particular, where the government has tried to tax companies on their global income, this push back has taken the form of trapped cash, as companies hold trillions of dollars of cash on foreign shores, and inversions, where some US companies have chosen to move their home base to more favorable tax locales.

Declining cross-market correlations: As companies globalize, it should come as no surprise that the correlations across global equity markets have climbed, with two immediate consequences. The first is that global crises are now an almost annual occurrence rather than uncommon surprises, as pain in one market quickly spreads across the world. The second is that the salve of geographic diversification, long touted as protection against domestic market shocks, provides far less protection than it used to.

The bottom line is that there is no place to hide from country risk, and as with any other type of risk, it is best to face up to it and deal with it explicitly.

Country Risk - Default Risk Measures

The simplest and most easily measured country risk is the risk of sovereign default. When countries default on their obligations, it is not just the government that feels the pain but companies, consumers and investors do, as well.

Sovereign Default: Frequency and Consequences

Governments borrow money, both from their own citizens and from foreign entities, and they sometimes borrow too much. Some of these government default, not only on their foreign currency debt but also on their local currency debt, with the latter having become more common over time:

Source: Fitch Ratings

You may be puzzled by local currency debt defaults, since governments do have the capacity to print more of their own currency, but faced with a choice between defaulting or debasing their currencies, many governments choose the latter. When default occurs, the immediate pain is felt by the government and lenders, the former because it loses the capacity to borrow more, and the latter because they don't get paid., but there is collateral damage:

Capital Market Turmoil: Liquidity dries up, as investors withdraw from equity and bond markets, making it more difficult for private enterprises in the defaulting country to raise funds for projects and resulting in sharp price drops in both bond and stock markets.

Real growth: Sovereign defaults are generally followed by economic recessions, as consumers hold back on spending and firms are reluctant to commit resources to long-term investments.

Political Instability: Default can also strike a blow to the national psyche, which in turn can put the leadership class at risk. The wave of defaults that swept through Europe in the 1930s, with Germany, Austria, Hungary and Italy all falling victims, allowed for the rise of the Nazis and set the stage for the Second World War. In Latin America, defaults and coups have gone hand in hand for much of the last two centuries.

Sovereign Ratings

The most accessible measures of sovereign default risk are sovereign ratings, with S&P, Moody's and Fitch all providing both local currency and foreign currency ratings for most countries around the world. While there are many who mistrust these ratings, they are widely used as proxies of country risk and changes in ratings, especially down grades, are news worthy and affect markets. The process and metrics used to arrive at the ratings are described more fully here and here but the picture below summarizes the sovereign ratings assigned to countries in July 2017 and the data can be downloaded at this link:

The last decade has turned the spotlight on both the pluses and minuses of ratings. On the plus side, as the ratings agencies are quick to point out, ratings and default spreads are highly correlated. On the minus side, ratings agencies seem to have regional biases (under rating emerging markets and over rating developed markets) and are slow to change ratings.

Sovereign CDS Spreads

In the last decade, we have seen the growth of a market-based measure of default risk in the Credit Default Swap (CDS) market, where you can buy insurance against sovereign default by buying a sovereign CDS. Since the insurance is priced on annual basis, the price of a sovereign CDS becomes a market measure of the default spread for that country. In July 2017, there were 68 countries with sovereign CDS and the picture below captures the pricing (with the data available for download at this link). One of the limitations of the CDS market is that there is still credit risk in the market and to allow for the upward bias this creates in the spreads, I compute a netted version of the spread, where I net out the US sovereign CDS spread of 0.34% from each country's CDS spread.

To provide a comparison between the CDS and sovereign rating measures of default risk, let me offer two example. The sovereign CDS for Brazil on July 1, 2017, was 3.46%. On the same day, Moody rated Brazil at Ba2, with an estimated default spread of 3.17%, close to the CDS value. For India, the sovereign CDS spread on July 1, 2017, was 2.42%, very close to the default spread of 2.32% that would have been assigned to it based upon its Baa3 rating.

Country Risk - Institutional Risk

When investing in a company, the sovereign default risk is just one of many risks that you have to factor into your decision making. In fact, default risk may pale in comparison to risks you face because of the institutional structure, or lack of it, in a country. At the risk of picking at scabs, here is my shot at assessing some of these risks.

1. Corruption

Much as we like to inveigh against its consequences, corruption is not just part and parcel of operating in some parts of the world, but it takes on the role of an implicit tax, one that is paid to free agents, acting in their own interests, rather than to governments. Transparency International, an entity that measures corruption risk around the world, estimates corruption scores for individual countries and heir findings for 2016 are summarized in the picture below. To see where a country falls on the corruption continuum, you can either click on the live link below the picture or download the data by country by clicking here.

While it is easy to fall back on cultural stereotypes to explain differences across countries, there is a high correlation between economic well being and corruption. Thus, while much of Latin America scores low on the corruption, Chile and Uruguay rank much higher, as do South Korea and Japan in Asia.

2. Legal Protections

Even the very best investments are only as good as the legal protections that you have as an investor, against expropriation or theft, which is why the property right protections rank high on investor wish lists. To measure the strength of property rights, I turned to the International Property Rights Index (IPRI), and report the scores they assigned in their most recent update in 2016, to countries in the picture below. You can click on the live link below the picture or download the data here.

Europe, North America, Japan and Australia all score high on property rights, but the hopeful sign is that index itself has seen increasing respect for property rights across time and Venezuela and Myanmar are now more the exception, than the rule.

3. Risk of violence

It is difficult to do business, when you have bullets whizzing by and bombs going off around you. Holding all else constant, you would prefer to operate in parts of the world that are safer rather than riskier. To measure exposure to violence, I again turn to an external entity, Vision of Humanity, and reproduce their Global Peace Index in the picture below (with link to live map and to data):

In keeping with the adage that when it rains, it pours, the countries that are most susceptible to corruption and have weak property rights also seem to be most exposed to physical violence.

Country Risk - Equity Risk

As you can see, there are multiple dimensions on which you can measure country risk, leading to different scores and rankings. As an investor in the country, you are exposed to all of these risks, albeit to varying degrees, and you have to consider all these risks in making decisions. Consequently, you would like (a) a composite measure of risk that (b) you can convert into a metric that easily fits into your investment framework.

1. Country Risk Scores

There are several services that provide composite measures of country risk, including the Economist, Euromoney and Political Risk Services (PRS). These country risk measures take the form of numerical scores, and in the heat map below, I report the change in the PRS country risk score between July 2016 and July 2017 and categorize countries based on the direction and magnitude of the change. Here, as in the prior pictures, you can see the PRS scores and the change, by country, by either clicking on the live map link below the picture or download the data by clicking here).

Based on the PRS scores, the vast majority of emerging markets became safer during the time period between July 2016 and July 2017, with the biggest improvements in Latin America and Asia. The North American countries saw risk go up, as did pockets of Africa and South East Asia. The problem with country risk scores, no matter how well they are measured, is that they do not fit a standardized framework. Just to provide an illustration, PRS scores are low for risky countries and high for safe countries, whereas the Economist risk scores are high for risky countries and low for safe countries.

3. Equity Risk Premiums

To incorporate and adjust for country risk into investing and valuation, I try to estimate the equity risk premiums for country, with riskier countries having higher equity risk premiums. I start with the implied equity risk premium for the US, which I estimate to be 5.13% at the start of July 2017 as my mature market premium and add to it a scaled up version of the default spread (based upon the rating); the scaling factor of 1.15 is based upon the relative volatility of emerging market equities versus bonds. You can see a more detailed description of the process in the paper that is linked at the end of this post. You can look up the equity risk premium for an individual country by clicking on the live map link or download the data by clicking here.

These equity risk premiums are central to how I deal with country risk in valuation, as I will explain in the last section of this post.

Closing the Loop

When valuing companies that have substantial exposure to country risk, it is easy to get overwhelmed by the variety of risks. To keep the process under your control, you should start by breaking country risk into three buckets: risk that is specific just to that country, risk that is macro/global and discrete risks that are potentially catastrophic (such as nationalization or terrorism). Each has a place in valuation, with country specific risks incorporated into expected cash flows, macro economic risks in the discount rate and discrete risks in a post-valuation adjustment.

1. Adjusting discount rates

The key to a clean country risk adjustment, when estimating discount rates, is to make sure that you do not double or even triple count it. With the cost of equity for a company, for instance, where there are only three inputs that drive the cost, it is only the equity risk premium that should be conduit for country risk (hence explaining my earlier focus on equity risk premiums, by country). The risk free rate is a function of the currency that you choose to do your valuation in and the relative risk measure (or beta, if that is how you choose to measure it) should be determined by the business or businesses that the company operates in.

If you are discounting the composite cash flows of a multinational company, the equity risk premium should be a weighted average of the equity risk premiums of the countries that the company operates in, with the weights based on revenues or operating assets. If you are valuing just the operations in one country, you would use the equity risk premium just for that country.

2. Expected cash flows

With risks that are specific to a country, it is better to incorporate the risks into the expected cash flows. Thus, if a country is rife with corruption, you could treat the resulting costs as part of operating expenses, reducing profits and cash flows. When legal and regulatory delays are a feature of business in a country, you can build in the delay as lags between investing and operations. When violence (from terrorism or war) is part and parcel of operations, you may want to include a cost of insuring against the risk in your cash flows.

None of these adjustments are easy to make, but it is worth remembering that incorporating the risk into your cash flows is not risk adjusting the cash flow, since the latter requires replacing the expected cash flow with a certainty equivalent one. Where does currency risk play out? When converting cash flows from one currency (foreign) to another (domestic), you should bring in expected devaluation or revaluation into expected exchange rates. If you want to hedge exchange rate risk, you can incorporate the cost of heeding into your cash flows but it is not clear that you should be adjusting discount rates for that risk, since investors can diversify it away.

3. Post-Valuation Adjustment

There are some risks that are rare, but if they occur, can be devastating, at least for investors in a business. Included in this grouping would be the risk of nationalization and terrorism. These risks cannot be incorporated easily into discount rates and adjusting expected cash flows in a going concern valuation (DCF) for risk that a company will be nationalized or will not survive is messy.

Thus, to estimate the effect that nationalization risk will have on the value of a business, you will have to assess the probability that the business will be nationalized and the value that you will receive as owners of the business, in the event of nationalization.

Danger and Opportunity

One of my favorite definitions of risk is the Chinese symbol for crisis, a combination of the symbols for danger and opportunity.

危機

With risky emerging markets, this comes into , I am reminded that to have one (opportunity), I have to be willing to live the other (danger). Blindly ignoring these markets, as some conservative developed market companies are inclined to do, because there is danger will lead to stagnation, but blindly jumping into them, drawn by opportunity, will cause implosions. The essence of risk management is to measure the danger in markets and then gauge whether the opportunities are sufficient to compensate you for the dangers. That is what I hope that I have laid the foundations for, in this post.

9 comments:

How do we adjust for equity risk when, say, company has 85% of sales abroad, but they're really just inputs to be mixed in final product for re-export back to home country? I believe this is the case with a lot of the petrochemical exports from USA to Mexico, ultimately coming back into Texas as final products for consumption in USA and Canada.

"In 2014, two companies, Accenture and Seagate Technology, reported that all their sales were foreign, making them US companies only in name."

Professor, would you mind clarifying this statement? I read the sentence as implying that all of Accenture's and Seagate's revenue are outside the U.S. Which of course makes no sense as my work has used Accenture’s consulting services and I’ve purchased a Seagate hard drive for my P.C., both would be a U.S. transaction. Accenture and Seagate are incorporated in Ireland, perhaps this skews the data?

On an unrelated note, what's your take on the forthcoming Saudi Aramco IPO? A $2 trillion valuation seems a bit optimistic given the likely corporate governance issues and assumption of unprofitable contracts with Saudi gov't.

accenture: Net Revenues by Geographic Region (2016)Net revenues by geographic region for the full fiscal year were as follows: North America: $15.65 billion, compared with $14.21 billion for fiscal 2015, an increaseof 10 percent in U.S. dollars and 11 percent in local currency. Europe: $11.45 billion, compared with $10.93 billion for fiscal 2015, an increase of5 percent in U.S. dollars and 11 percent in local currency. Growth Markets: $5.78 billion, compared with $5.91 billion for fiscal 2015,

I’m student of BBA and studied banking & finance as subject, now I’m thinking about to choose it as specialized subjects. My personal interest is in banking, which is allowing me to go through it. Thanks for sharing such an informative post. Keep it up.

Apparently, the American trope about 'crisis' being a combination of 'danger' and 'opportunity' in Chinese is a mis-translation.

See https://en.wikipedia.org/wiki/Chinese_word_for_%22crisis%22("Referencing the word has since become a staple meme for American business consultants and motivational speakers, as well as gaining popularity in educational institutions, politics and in the popular press")